Upload
rikesh-daliya
View
225
Download
0
Embed Size (px)
Citation preview
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 1/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 1
Linkage between Stock Market Volatility and the
Introduction of Index Futures in India
A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT OF
THE REQUIREMENTS FOR THE AWARD OF MBA DEGREE OF
BANGALORE UNIVERSITY.
Submitted By
Sachna Sundar
Reg.No -03XQCM6086
UNDER THE GUIDANCE OF
Sri. T.V.N. Rao
INTERNAL GUIDE
M.P.BIRLA INSTITUTE OF MANAGEMENT
ASSOCIATE BHARTIYA VIDYA BHAVAN.
BANGALORE-560001
2003-2004
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 2/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 2
CHAPTER 1
INTRODUCTION
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 3/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 3
Background of Indian Financial Markets:
Financial markets in India have been largely synonymous with the Stock
markets. There were several reasons for this. Being a largely agrarian based
economy, the farming community was a completely protected one and the socialistic
policies followed by successive governments led to the image that trading in
commodities was something that was almost “un-Indian”. Therefore, commodity-
trading exchanges were never ever encouraged.
To this day, the vast majority of the trading taking place in the different
commodity markets in the country is all dominated by forward contracts between
actual producers and wholesalers/exporters etc. Further, the Indian economy being
a closed one, foreign exchange trading was something entirely, well, foreign. We
also had some kind of protectionism in the Gold and Silver markets and there was a
ban, until recently, on any kind of export or import of these metals. Therefore, this
market too could not develop like their counterparts in the other parts of the world.
This left only the Stock Markets as an arena where man could express one of his
natural instincts to trade. The rapid industrialization and the continued socialistic
policies of the seventies led to the FERA dilution which was the major impetus to this
market, led to greatly increased public interest in the markets. The era of the IPO
(initial public offering) was born and the stock market became the place for
investment.
As the markets grew, slowly, a need for some kind of a hedging mechanism
was felt by the players of the stock markets, now that the game had gotten a lotbigger than it ever was. The BSE Index during this period had risen from the sedate
200-300 ranges of the early eighties to 4500 in the mid nineties. This was a huge
rise and the decline that set in from there was also much, much larger than what had
been experienced by the players until then. By then the Mutual Fund industry had
also got established in the Indian markets.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 4/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 4
The only known hedging mechanism in the market was a system known as
“badla”. This system functioned well when stocks had to be sent for transfer and the
financier was protected from any adverse stock price moves by taking a position in
the budla market. This system was imperfect but served the purposes of most
traders and financiers. But since mutual funds were not allowed to participate in this
market, it remained the fiefdom of brokers and traders. This led to periodic abuses of
the system by different brokers and market operators, the most recent one being the
manipulation of the budla market at the CSE by Ketan Parekh and his coterie.
SEBI, which had come into existence by 1993, was slowly flexing its muscles
over the years, trying to bring some kind of discipline into the market and relaxing
the stranglehold that the brokers and operators had over the stock markets. With
every passing year, SEBI gathered more and more teeth and finally, in the year
2000, they managed to get the exchanges to start a Futures and Options segment.
The markets started trading in Futures in 2000 and in 2001, the options market also
began. This was a landmark event in the evolvement of our financial markets to
world standards.
Financial Derivatives Market and its Development in India:
Financial markets are, by nature, extremely volatile and hence the risk factor
is an important concern for financial agents. To reduce this risk, the concept of
derivatives comes into the picture. Derivatives are products whose values are
derived from one or more basic variables called bases. These bases can be
underlying assets (for example forex, equity, etc), bases or reference rates. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate
the risk of a change in prices by that date. The transaction in this case would be the
derivative, while the spot price of wheat would be the underlying asset.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 5/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 5
Development of exchange-traded derivatives:
Derivatives have probably been around for as long as people have been
trading with one another. Forward contracting dates back at least to the 12th centuryand may well have been around before then. Merchants entered into contracts with
one another for future delivery of specified amount of commodities at specified price.
A primary motivation for pre-arranging a buyer or seller for a stock of commodities in
early forward contracts was to lessen the possibility that large swings would inhibit
marketing the commodity after a harvest.
Introduction to Index:
An Index is used to summarize the price movements of a unique set of goods
in the financial, commodity, forex or any other market place. Financial indices are
created to measure price movements of stocks, bonds, T-bills and other type of
financial securities. More specifically, a stock index is created to provide investors
with the information regarding the average share price in the stock market. Broad
indices are expected to capture the overall behavior of equity market and need torepresent the return obtained by typical portfolios in the country.
• The primary function of a stock index is to serve as a barometer of the equity
market. The ups and downs in the index represent the movement of the
equity market. Any investor can look at the performance of the index to find
out how the equity market is doing.
• The availability of an index lends itself to forecasting of the market conditions
by technical analyst. Technical analysts believe that historical share price
movements can be used to predict the future price movements. They use the
stock index data to forecast which direction the market is likely to move in
near future.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 6/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 6
• The most important use of an equity market index is as a benchmark for a
portfolio of stocks. All diversified portfolios, belonging either to retail investors
or mutual funds, use the common stock index as a yardstick for their returns.
• Finally Indices are useful in modern financial applications of derivatives.
Indices serve as the underlying for futures and options products and also for
the Exchange Traded Funds.
SENSEX:
SENSEX is India's first Index compiled in 1986. It is a basket of 30 constituent
stocks representing a sample of large, liquid and representative companies. The
base year of BSE-SENSEX is 1978-79 and the base value is 100. The index is
widely reported in both domestic and international markets through print as well as
electronic media.
Due to its wide acceptance amongst the investors, SENSEX is regarded to be
the pulse of the Indian stock market. All leading business newspapers and the
business channels report SENSEX, as it is the language that all investors
understand.
As the oldest index in the country, it provides the time series data over a fairly
long period of time (from 1979 onwards) to be used for various research purposes.
The Index Cell of the exchange is responsible for the day-to-day maintenance of the
index within the broad index policy set by the Index Committee. The Index Cell
ensures that the SENSEX and all other BSE indices maintain their benchmark
properties by striking a delicate balance between frequent replacements in index
and maintaining its historical continuity.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 7/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 7
NIFTY:
The Nifty is relatively a new comer in the Indian market. S&P CNX Nifty is a
50 stock index accounting for 23 sectors of the economy. It is used for purposes
such as benchmarking fund portfolios; index based derivatives and index funds. The
base period selected for Nifty is the close of prices on November 3, 1995, which
marked the completion of one-year of operations of NSE's capital market segment.
The base value of index was set at 1000.
S&P CNX Nifty is owned and managed by India Index Services and Products
Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is a specialized
company focused upon the index as a core product. IISL have a consulting and
licensing agreement with Standard & Poor's (S&P), who are world leaders in index
services.
What are Derivatives?
The term "Derivative" indicates that it has no independent value, i.e. its value
is entirely "derived" from the value of the underlying asset. The underlying asset can
be securities, commodities, bullion, currency, live stock or anything else. In other
words, Derivative means a forward, future, option or any other hybrid contract of pre
determined fixed duration, linked for the purpose of contract fulfillment to the value of
a specified real or financial asset or to an index of securities.
With Securities Laws (Second Amendment) Act, 1999, Derivatives has been
included in the definition of Securities. The term Derivative has been defined in
Securities Contracts (Regulations) Act, as:
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 8/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 8
A Derivative includes:
SA security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security;SA contract which derives its value from the prices, or index of prices, of
underlying securities.
Types of Derivatives:
Forwards:
A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price.
Futures:
A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types
of forward contracts in the sense that the former are standardized exchange-tradedcontracts
Options:
Options are of two types - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to sell
a given quantity of the underlying asset at a given price on or before a given date.
Warrants:
Options generally have lives of upto one year; the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated
options are called warrants and are generally traded over-the-counter.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 9/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 9
LEAPS (Long-Term Equity Anticipation Securities):
The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.
Baskets:
Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a
form of basket options.
Swaps:
Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as portfolios of
forward contracts.
The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps : These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.
Swaptions:
Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than
have calls and puts, the swaptions market has receiver swaptions and payer
swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer
swaption is an option to pay fixed and receive floating.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 10/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 10
Structure of Derivative Markets in India
Derivative trading in India takes can place either on a separate and
independent Derivative Exchange or on a separate segment of an existing StockExchange. Derivative Exchange/Segment function as a Self-Regulatory
Organization (SRO) and SEBI acts as the oversight regulator. The clearing &
settlement of all trades on the Derivative Exchange/Segment would have to be
through a Clearing Corporation/House, which is independent in governance and
membership from the Derivative Exchange/Segment.
Types of Derivative Contracts Permitted by SEBI:
Derivative products have been introduced in a phased manner starting with
Index Futures Contracts in June 2000. Index Options and Stock Options were
introduced in June 2001 and July 2001 followed by Stock Futures in November
2001.
Minimum Contract Size:
The Standing Committee on Finance, a Parliamentary Committee, at the time
of recommending amendment to Securities Contract (Regulation) Act, 1956 had
recommended that the minimum contract size of derivative contracts traded in the
Indian Markets should be pegged not below Rs.2 Lakhs. Based on this
recommendation SEBI has specified that the value of a derivative contract should
not be less than Rs.2 Lakh at the time of introducing the contract in the market.
The Lot Size of a Contract:
Lot size refers to number of underlying securities in one contract. Additionally,
for stock specific derivative contracts SEBI has specified that the lot size of the
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 11/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 11
underlying individual security should be in multiples of 100 and fractions, if any,
should be rounded of to the next higher multiple of 100. This requirement of SEBI
coupled with the requirement of minimum contract size forms the basis of arriving at
the lot size of a contract
For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the
minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands
to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
SEBI Amendment to Stipulations on Lot Size:
While the Legislative body stipulated the minimum contract size in terms of
value (Rs.2 Lacs), the system of standardising securities trade in Lots, had a
multiplying effect, on the minimum value of a contract, when the prices of the
premium Scrips started appreciating over time. BSE Index (Sensex) which was less
than 3000 at that time swelled to nearly 6500 presently. As the value of individual
scrips increased, smaller number of such scrips would be sufficient to cover the
minimum contract value of Rs.2.00 Lacs prescribed by the Standing Committee of
the Parliament. But stipulating a fixed number of shares as the lot in many cases
swelled the value of the contract to Rs.5 Lacs and even more in many cases. This
brought derivatives trading beyond the scope of the small investor.
Considering the fact SEBI revised its stipulations regarding Lot size, but
retaining the minimum contract value at Rs.2 Lacs and issued a press release on
07.01.2004 stating:
“It has been noticed that in several derivative contracts the value hasexceeded Rs.2 lakh. In such cases it has been decided to reduce the value of the
contract to close to but not less than Rs.2 lakh by using an appropriate lot size /
multiplier which could be half or 50%. The exchanges could determine any other lot
size / multipliers to keep the contract size of derivatives close to Rs.2 lakh, but in any
case not less than Rs.2 lakh. The exchanges would be able to reduce the contract
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 12/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 12
size of a derivative contract by submitting a detailed proposal to SEBI and after
giving at least two weeks prior notice to the market. For each index there may be a
different multiple for determining the price of the futures contract.”
For example, the S&P 500 index is one of the most widely traded index
futures contracts in the U.S. Often stock portfolio managers who want to hedge risk
over a certain period of time will use the S&P 500 index future to do so. By shorting
these contracts, stock portfolio managers can protect themselves from downside
price risk of the broader market. However, by using this hedging strategy, if perfectly
done, the manager' s portfolio will not participate in any gains on the index; instead
the portfolio will lock in gains equivalent to the risk-free rate of interest.
Alternatively stock can use index futures to increase their exposure to
movements in a particular index, essentially leveraging their portfolio.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 13/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 13
AN INTRODUCTION TO FUTURES
For a trade to take place, what you need is two people- one with some goods
to sell and the other to buy it. The process of the trade will consist of both theseparties expressing their individual interests- one to buy and the other to sell – and
then they get into an auction process so as to decide the price. Once there is an
agreement on the price, the two shake hands and a transaction is complete. Where
multiple buyers and sellers congregate and multiple trades begin to occur, is called a
market. There are two ways that a trade can take place. One, the goods are
physically exchanged for money (like in a retail shop) or two; there could be a
transaction in a “promise” to deliver the goods at a future point of time for a price
agreed upon in the present.
This kind of transaction was the norm where the goods were expected to
arrive or be ready for shipment after a while – such as in Crops or commodities that
were imported or exported from other lands. The people dealing in such items would
be either the producer of it or a consumer of it. For example, a wheat farmer would
be quite interested in ensuring that he gets a good price for his crop – when he is
ready with it – from the bread manufacturer (who is the consumer of his product).
In the same fashion, the bread manufacturer is equally interested in tying up
good and consistent supply of wheat so that he can produce his goods (i.e. bread)
uninterrupted. This need of both parties is met by the formation of the “Forward
Market” or a market that deals in the present for value to be settled at some point of
time in the future.
Such Forward markets have existed ever since trade began. They had some
imperfections within them and this led the traders to form what came to be known
subsequently as the Futures markets.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 14/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 14
What is a Futures Contract?
Futures Contract means a legally binding agreement to buy or sell the
underlying security on a future date . Future contracts are the organized/standardized
contracts in terms of quantity, quality (in case of commodities), delivery time and
place for settlement on any date in future. The contract expires on a pre-specified
date which is called the expiry date of the contract. On expiry, futures can be settled
by delivery of the underlying asset or cash. Cash settlement entails paying/receiving
the difference between the prices at which the contract was entered and the price of
the underlying asset at the time of expiry of the contract.
Futures Contract Details:
The Index futures commenced trading in June 2000. The exchanges
commenced Options trading in June 2001 with options on Index and in July 2001
with options on individual stocks. The sensex and nifty are the two designated
indices for Futures and Options trading. 31 leading stocks have been designated for
options trading. These have been selected on the basis of some stringent conditions
and parameters laid down by SEBI.
The Sensex futures contract trades with a 50 multiple while the Nifty contract
has a 200 multiple. Translated, this means that one futures contract of the Sensex
would mean 50 Sensex while one Nifty contract would get you 200 Nifty. Hence
every point move in the sensex would mean a 50-point change in the value of the
contract and 200 in the nifty contract. Or, in other words, if one is long index futures,
for every one point move of the sensex, one would get a profit or loss of Rs.50 and it
would be Rs.200 for the nifty.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 15/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 15
It should be realized that derivative products have a short life. They are
designated by the time when they are said to “expire”. That is, the date of expiry is
the last day of trading. After that date, a new contract has to be entered into. The
exchanges have standardized the life of the contracts on both futures and options to
three months. We have therefore futures and options on indices as well as stocks for
the current month and the next two months. In the jargon, they are referred to as the
Near month, the mid month and the far month contracts. Hence we would have July
Nifty future, August Nifty and September Nifty (or Sensex) at the moment as the
three contract months trading.
What are Index Futures Contracts?
Futures contract based on an index i.e. the underlying asset is the
index, are known as Index Futures Contracts . For example, futures contract on
NIFTY Index and BSE-30 Index. These contracts derive their value from the value of
the underlying index.
An index in turn derives its value from the prices of securities that constitute
the index and is created to represent the sentiments of the market as a whole or of a
particular sector of the economy (Sectoral Index).
By its very nature, index cannot be delivered on maturity of the Index futures
contracts therefore, these contracts are essentially cash settled on Expiry.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 16/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 16
Types of Players: The Participants in a Derivatives Market:
The market is composed of all types of players with all kinds of strategies and
desire for the end outcome. While everyone is engaged in either buying or selling, it
is motive or the strategy behind the buying or selling that differentiates the players.
Accordingly, we can make the following classifications.
SSpeculators: They use futures and options contracts to get extra leverage in
betting on future movements in the price of an asset. They can increase both
the potential gains and potential posses by usage of derivatives in a
speculative venture.
SHedgers: They use futures or options markets to reduce or eliminate the risk
associated with price of an asset.
SArbitrageurs: They are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, they see the futures
price of an asset getting out of line with the cash price, they will take offsetting
positions in the two markets to lock in a profit.
1) Traders or Speculators:
They have a definite view about the directionality of the market for the future.
Hence they take up positions that will benefit them from the movement of the
underlying. In the futures markets, traders would take up long positions or buy the
futures at current rates with an expectation that it would move up in the coming days
and give them profits before the contract expires. If their view were bearish, then
they would sell the futures contract at current prices and expect it to decline as the
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 17/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 17
market goes lower and then would buy it back and make a profit out of the
difference. This process is called short selling.
In the options markets, speculators would buy Call options (the right to buy) if
they felt the market would rise or buy Put options (the right to sell) if they felt the
market would decline. They can then either hold the position until expiry or they
could square off the deal if some profits are available before the expiry date. The
difference between the purchase and sale price of the future or the option contract
would determine the profit or loss in the transaction.
For example, if one is bullish on the market, one can buy an August Future
which, say, is currently quoting at 1065 (current index level is 1060) if one expects
that the index would be moving up by August. If this supposition is correct and the
index moves up to, say, 1100, the August futures would be salable around 1105 or
so. Thus the buyer of the future contract would net a gain of about 40 points less the
transaction costs. Since each point move on the nifty index is equal to Rs.200, this
would be a profit of Rs.8000 on every contract of nifty that is purchased. If one is
bearish on the nifty and thinks that the level of nifty in September would be 1000,
then one can sell the September future contract currently trading at 1070. If the view
is correct and the nifty level in September is indeed 1000, then the September future
contract by that time would also have declined to around 1005 or so. One can then
buy back what is sold and net a gain of 65 points amounting to Rs.13000 per
contract. Of course, if one is wrong in the view and the market rises, say to 1120 by
September, then the contract would be trading around 1125 and one would then
incur a loss of 55 points or about Rs.11000 per contract.
2) Hedgers:
This is one of the most common usages of the futures and options contracts.
This is done by players who hold stocks, like Mutual Funds, and who would like to
protect the value of the portfolio during the times when the market is bearish.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 18/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 18
Typically, they would look to participate in the futures-options markets during bearish
times. If the market were expected to fall, then a mutual fund manager would seek to
sell the Index future of a value equivalent to his portfolio. Why should one do this?
Because the law relating to mutual funds requires that the money raised should be
deployed in equities up to a certain minimum percentage.
Thus, a fund would always remain invested to that extent and only the
balance portion would be held in non-equity instruments. If the market falls, the fund
would then take a hit in the values of its holding. By selling index futures and buying
them back at a later, lower price, the fund has recouped its losses on the equity side
with a profit made on the futures trade. Thus the value of the fund is saved (to a
large extent) from eroding. This protects the Net Asset Value (NAV) of the fund and
thereby the investors in that mutual fund are also protected from erosion of their own
net worth.
Alternatively, the fund manager can also buy Puts on the index or the
individual stocks that he holds and thereby participate in the decline of the market
without selling out his holding. Again, the loss in equities value is made up by the
profits in the Put options.
It is to be noted here that Hedging does not make profits. It only contains the
losses.
3) Arbitragers:
These are set of players who try to take advantage of mispricing that
periodically occur in the market due to different sets of reasons. There could be a
difference in pricing between the underlying asset and what is known as the “fair
value” of the future instrument (either Futures or Options). There could be a
mispricing between different futures instruments themselves owing to changes in
volatility of the market or temporary supply-demand changes.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 19/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 19
There are multiple reasons why mispricing will occur. Arbitragers keep a keen
watch on the prices and take advantage of the situation by buying and selling the
two instruments simultaneously to lock in the difference. For example, if the current
index level is 1060 and the fair value of July Nifty is 1080 but it is currently quoting at
1090, then an arbitrager would quickly sell the future contract at 1090 and buy the
cash index at 1060. This is because he sees that the correct spread between the
two should be 20 points while currently it has expanded to 30 for some reason. He
will then square off the transaction when the nifty returns to the “normal” spread of
20 points and thereby net a profit of 10 points. Similarly, one can also spot the
mispricing in option contracts and seek to profit from this. The trading of this kind is
almost a risk free venture but requires a keen eye and quick action. Arbitragers
impart a great amount of liquidity to the system.
The Need for Derivative Markets:
The word derivative means “derived from” or an “offshoot of” some other item.
The need for derivative products arose out of the basic need to hedge or control
risks in financial trades. The futures markets evolved out of business people’s need
to transfer the risk of carrying inventory to the speculators who were willing to bear
that risk, hoping to profit by a gain in the value of the commodity or stock. Before
proceeding further, therefore, it is necessary to understand the nature of risk. In the
stock markets, there are two kinds of risks:
The stock related risk – that which relates to the performance of the
company, its industry, and the market related risk – that which is connected with
factors other than the company but which impact the market as a whole.
While it is agreed that most of the stocks purchased by investors and mutual
funds would be (or should be) as a result of adequate research into the
fundamentals of the stock and its industry, it would be very difficult to account for all
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 20/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 20
the factors that go to affect the market as a whole. The number of variables, which
affect the market as a whole, are too numerous even to list. Hence, any stock
positions carries with it an element of the market as, being a part of the market, it
would represent the entire market as a microcosm. If one wanted to have a situation
where the outcome of the stock’s price was a function of its individual performance
within that industry alone, then it is obvious that there has to be one way of
eliminating the risks associated with the market as a whole. This was done through
the use of financial futures and options.
Hence, the concept of a derivative product on the stocks and indices (and in
the rest of the world, commodities and currencies) arose with an idea of shifting the
risk to people who were willing to accept them. Every market needs an element of
speculation. It is undeniable that speculation intrinsic of man’s nature. But it plays a
very useful function in the markets by increasing or providing the much needed
liquidity, without which, most markets would become quite volatile and price stability
a mirage. Hence, in order to encourage the flow of volumes, financial re-engineering
in the form of Futures and Options on stocks and indices were invented.
Economic Functions Performed by Derivatives:
1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk
averse people in greater numbers
5. They increase savings and investment in the long run
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 21/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 21
Economic Relevance of Futures Markets:
The most important role that the futures markets perform is in aiding the
process of proper price discovery. Since several different types of players areengaged in trading the futures markets with different intentions, it leads to a correct
pricing of the asset. This has important fall out, especially in the commodity and
currency markets. It prevents incorrect extension of trends that would be harmful to
the general public and thereby leads to greater market efficiency.
The presence of a larger number of tradable instruments also leads to a more
complete market, one where every type of player can have the maximum number of
features which will permit him to participate to the fullest extent in the markets. The
proper design of the futures products and the framework of trading help to contain
the risks in investments for different players. This leads to a more reliable and longer
lasting system.
Factors Driving the Growth of Financial Derivatives:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international
markets,
3. Marked improvement in communication facilities and sharp decline in their
costs,
4. Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets leading to higher returns,
reduced risk as well as transactions costs as compared to individual financial
assets.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 22/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 22
Summary:
The advent of the futures markets in India is a welcome addition to the
number of instruments that is currently available to the individual trader and investoras well as the institutional players. One need no longer bemoan the lack of hedging
facilities in the market and this is one of the most bullish developments for the long
term. The Indian stock markets can now begin attracting entirely newer set of
players who were hitherto hesitant to enter the stock markets because of the
absence of risk containing measures. The world over, the experience has been that
the cash market has multiplied several fold with the introduction of the Futures
markets, particularly, options. The same may be expected to happen in India too.
We are therefore set for very exciting times ahead of us in the markets. The entire
face of the stock markets as we knew it is set to change. Truly, we are now about to
catch up with the rest of the world.
Due to the introduction of index futures, the stock market volatility gets
affected. This is an attempt to study the impact of allowing the index futures trading
on the stock market by using one of the measures of volatility. The method is based
on close-to-close price, to measure volatility. This also attempts to find out how the
futures market volatility affects the underlying stock market volatility. The stock
market gets more matured, and the volatility in the stock market gets reduced to a
considerable extent by the introduction of index futures in India.
The Indian capital market has witnessed a major transformation and structural
change during the past one decade, as a result of the ongoing financial sector
reforms since 1991, in the wake of policies of liberalization and globalization. The
major objectives of these reforms have been to improve the market efficiency,
enhance transparency, check unfair trade practices, and bring the Indian market up
to international standards.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 23/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 23
As a result of the reforms, several changes have also taken place in the
operations of the secondary markets such as automated on-line trading in
exchanges, enabling trading terminals of the National Stock Exchange (NSE) and
Bombay Stock Exchange (BSE) to be available across the country, and making the
geographical location of an exchange irrelevant reduction in the settlement period,
opening of the stock markets to foreign portfolio investors etc. In addition to these
developments, India is perhaps one of the real emerging markets in the South Asian
region that has introduced derivative products on two of its main existing exchanges
in June 2000, to provide tools for risk management investors. These had, however,
been a considerable debate on the question of whether derivatives should be
introduced in India or not.
The LC Gupta Committee on Derivatives, which examined the whole issue in
details, had recommended the introduction of stock index futures in the first place in
1997.The preparation of regulatory framework for the operations of the derivatives
contracts took another three and a half years more, as it required not only an
amendment in the securities contracts (Regulation) Act, 1956 but also the
specification of the regulations for such contracts.
Finally, the Indian capital market saw the launching of index futures in June
2000 on two of the existing exchanges, viz., BSE and the NSE. A year later, options
on index were also introduced for trading on these exchanges. Later, stock options
on individual stocks were launched in July 2001.The latest product to enter in to the
derivative segment on these exchanges is contracts on stock futures in November
2001.Thus,with the launch of stock futures, a derivative product in India seems to be
complete.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 24/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 24
RESEARCH OBJECTIVES
The Objectives of the study are:
STo find out the impact of introduction of index futures on the stock market
volatility in India
STo find out how the futures market volatility affects the underlying stock
market volatility.
HYPOTHESES
The study tests the following hypotheses:
The Volatility of the underlying stock market has not changed after the
introduction of index futures. In statistical terms, hypotheses can be specified as
under:
H0: (before) � (after)
H1: (before) = (after)
There is no significant difference between the relative volatility of the
underlying stock market and the futures market.
In statistical terms, the hypotheses are specified as under:
H0: (Index Futures) � (Spot Index)
H1: (Index Futures) = (Spot Index)
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 25/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 25
Significance of the study:
Not much of research has been undertaken in this area .This
study helps in understanding how the introduction of Index Futures has affected theIndian stock market.
Among all the innovations that have flooded the international
financial markets, financial derivatives occupy the driver' s seat.Derivatives are
financial instruments whose values depend on the values of underlying assets.
So it is important to study the effect of Index Futures and how it
affected Indian Stock Market
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 26/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 26
CHAPTER 2
REVIEW OF LITERATURE
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 27/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 27
RREEVVIIEEWW OOFF LLIITTEERRAATTUURREE::
The introduction of equity and equity index derivative contracts in Indian
market has not been very old but today the total notional trading values in
derivatives contracts are ahead of cash market. On many occasions, the derivatives
notional trading values are double the cash market trading values. Given such
dramatic changes, we would like to study the behaviour of volatility in cash market
after the introduction of derivatives.
Impact of derivatives trading on the volatility of the cash market in India has
been studied by Thenmozhi (2002), Shenbagaraman (2003), Gupta and Kumar
(2002) Gupta and Kumar (2002) did find that the overall volatility of underlying
market declined after introduction of derivatives contracts on indices. Thenmozhi
(2002) reported lower level volatility in cash market after introduction of derivative
contracts. Shenbagaraman (2003) reported that there was no significant fall in cash
market volatility due to introduction of derivatives contracts in Indian market.
Raju and Karande (2003) reported a decline in volatility of the cash market
after derivatives introduction in Indian market. All these studies have been done
using the market index and not individual stocks.
These studies were conducted using data for a smaller period and when the
notional trading volume in the market was not significant and before tremendous
success of futures on individual stocks.
Today derivatives market in India is more successful and we have more than
3 years of derivatives market. Hence the present study would use the longer period
of data to study the behaviour of volatility in the market after Index Futures was
introduced. The study uses S& P CNX Nifty close to close values for analysis.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 28/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 28
CHAPTER 3
METHODOLOGY
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 29/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 29
METHODOLOGY:
The data employed in the study consists of daily prices of major stock market
index viz., the S&P CNX Nifty Index (henceforth Nifty Index) for a four and a halfyear period from June 8, 1998 to December 31, 2002.For this index, two sets of
prices were used. These were daily open and close.
Likewise, open and close prices were used for a period of one and a-half
year period i.e., from June 12, 2001 to December 31, 2002 for the Nifty Index
Futures contracts. The necessary data have been collected from the derivative
segments of this exchange.
The study has used measure of volatility.
In the first place, the daily returns based on closing prices were computed
using question:
Rt = ln (C t /C t-1)
Where,
C t and C t-1 are the closing prices on day t and t-1 respectively.
R t represents the return in relation to day t.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 30/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 30
Next, compute the variance of this return series to understand the inter –trade
volatility by using the equation:
T _
[2 = �5 t – R ) 2 / T -1
T =1
Where,
_ T
R = � (R 1) / T
T =1
The impact of introduction of futures contracts on the underlying stock market
has been examined by comparing the daily volatility measured by standard
deviation), before and after futures introduction in terms of measures based on
(Ct/Ct-1).
EMPIRICAL RESULTS:
The results pertaining to the question of whether or not there has been an
impact of introduction of index futures on the volatility of the underlying stock market,
for the index i.e., Nifty Index has been discussed in this research. Later, the results
relating to the relative volatility of index futures market and spot indices are
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 31/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 31
presented and discussed. Here again, the results are discussed separately for the
futures and the index.
IMPACT OF INTRODUCTION OF INDEX FUTURES ON STOCK
MARKET VOLATILITY:
The research now present and discuss the empirical results pertaining to the
impact of introduction of index futures contracts on the stock market volatility in
respect of both the indices.
Effect of Introduction of Index Futures on Nifty Index:
Tables 1 show the effect of introduction of index futures contracts on Nifty
Index in respect of ln (Ct/Ct-1), for several periods. Interestingly, the volatility of the
market seems to have declined post introduction of index futures for all the periods,
in respect of both these measures. In fact, expecting for the one-month period, theresults indicate that post introduction volatility of the Nifty Index has declined.
Though, for the one-month period too, the volatility seems to have declined, but it
was not found to be statistically significant. One possible explanation could be that
the market operators took time to understand the intricacies of the operations of the
futures market.
This is clearly reflected by the low level of futures market’s activities, both in
terms of number of contracts and the volume of trades done in the month of June
2000.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 32/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 32
Table 1
Effect of Introduction of Index Futures on Nifty
index
Ln (Ct / Ct-1) S. D. Before S. D. After
1 Month 0.02112554 0.012041698
2 Months 0.026118695 0.015133876
3 Months 0.026565963 0.014491243
6 Months 0.023574876 0.015735007
9 Months 0.021500522 0.015705916
12 Months 0.019974151 0.017032926
15 Months 0.020676 0.015793804
18 Months 0.020321 0.016246764
24 Months 0.020097 0.016142
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 33/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 33
RELATIVE VOLATILITY: INDEX FUTURES AND SPOT MARKETS:
The research shall now present and discuss the results of relative volatility of
futures and spot market in respect of both the indices, to see whether index futuresare more (less) volatile than the underlying spot index.
Daily Price Volatility: Nifty Index Futures and Nifty Index
Empirical results relating to relative volatility of Nifty Index futures and Nifty
Index Spot index are given in Tables3; Table gives the daily volatility for each monthfrom June 2001 to December 2002 for the near month Nifty Index Contracts, and for
the spot market on daily basis using the close-to-close volatility measure given by ln
(Ct/Ct-1).
In terms of the measure, though volatility of near month futures contracts is
higher in respect of 8 months out of 19 months, none of them, however, is
statistically significant. In fact, on comparison, volatility of futures and the spot
market does not seem to be different for any of the months studied. Similarly, for the
total period, the volatility for the markets is significantly different. Interestingly, here
volatility for the spot index was found to be higher in respect of 14 months out of 19
months. However, only in respect of three months viz., June 2001, November 2001
and August 2002, the spot index volatility was significantly higher than the near
month futures contracts.
However, for the overall period, the volatility for the market is not statistically
significant. .Here, too, the spot volatility was significantly higher than the near month
futures contracts for only for three months viz., June 2001,November 2001 and
August 2002.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 34/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 34
Table 2:Daily Price Volatility :Nifty Index Futures and Nifty Index
Ln (Ct/Ct-1) Observations S.D. of Nifty Index
Futures
S.D. of Nifty
Index
Year 2001
June 13 0.011814698 0.012580483
July 19 0.00975337 0.010228951
August 22 0.01054 0.005166508
September 19 0.02054 0.026272497
October 17 0.012624686 0.012219879
November 22 0.1372 0.012021396
December 19 0.014853755 0.012497081
Year 2002
January 19 0.01022 0.010062354
February 16 0.01130 0.015266788
March 20 0.03039 0.009197554
April 17 0.02325 0.011127738
May 22 0.00856 0.013542627
June 20 0.01170 0.011354597
July 19 0.00987 0.009863281
August 20 0.00413 0.008643585
September 19 0.02703 0.00734145
October 18 0.01225 0.008458243
November 20 0.01259 0.006921238
December 17 0.01139 0.009246714
Total Period 358
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 35/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 35
In sum, the results reported here indicate that the daily volatility by month for
the stock market and the futures market is not significantly different during the study
period. However, the overall volatility for the two markets was not found to be
significantly different from each other.
Analysis Of Variance (ANOVA)
sample n x bar x grand (x bar –xgrand)
sqr(xbar-x grand)
n*(sqr(xbar-x
grand)
1 502 0.00082 0.000133 0.000687 4.71E-07 0.000237
2 502 -0.00055 0.000133 -0.00068 4.67E-07 0.000235
sum 0.000471
variance 0.000471
variance 0.000319
f ratio 1.47542
f tab 3.84
f tab > f ratio so null hypothesis is accepted
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 36/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 36
Limitation of the Study:
As stock market volatility is effectively depicted with the help of GARCH
model the limitation of the study is the absence of the usage og this particular Model.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 37/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 37
CHAPTER 5
ANALYSIS AND DISCUSSION
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 38/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 38
The research gives the daily volatility for each month from June 2000 to
December 2001 for the near month index futures contracts, and for the stock market
using close-to- close volatility measure given by ln (Ct/Ct-1). In general, volatility of
near month futures contracts and the spot market does not seem to be different for
most of the months studied.
It is clear from the results obtained that the standard deviation of the NSE
index i.e. Nifty has been reduced after the introduction of the index futures. This
shows that volatility of Nifty has been reduced after the introduction of the index
futures.
Even though index futures have been introduced in June 2002, market took a
little time to understand the integrities of the index futures. Taking this into
consideration the data has been chosen from June 2001 to December 2002 in order
to accommodate the possible and obvious changes in the market conditions.
As the volatility of the index and the index futures are closely related there is
no much change in the volatility of both.
In sum, the results reported here indicate that the daily volatility by month for
the stock market and the futures market is not different during the study period.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 39/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 39
CHAPTER 6
CONCLUSION
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 40/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 40
CONCLUSION:
The attempt is made to examine the impact of introduction of index futures on
stock market volatility. Further, it has also examined the relative volatility of spot
market and futures market. The study utilized daily price data (open and close) of
the main index from the Indian stock market viz., S&P CNX Index for the four-and-
a-half year period from June 1998 to December 2002.Similar data for a one-and-a-
half year period from June 9, 2001 to December 31, 2002 have also been used for
Nifty index Futures contracts.
The study has used a measure of volatility first is based upon close-to-close
prices. The empirical results reported here indicated that the overall volatility of the
underlying stock market has declined after the introduction of the index futures on
both the indices, in terms of both the measures i.e., ln (Ct/Ct-1).There is no
conclusive evidence, which suggests that futures volatility is higher (lower) in
comparison to the underlying stock market for both the indices, in terms of all the
three measures used for estimating volatility.
In fact, there is some evidence that the futures volatility is lower in some
months, in comparison to the underlying stock market for both of these indices.
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 41/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
M P Birla Institute of Management 41
CHAPTER 7
REFERENCES
8/7/2019 Linkage Between Stock Market Volatility & Derivatves
http://slidepdf.com/reader/full/linkage-between-stock-market-volatility-derivatves 42/42
Linkage between Stock Market Volatility and the Introduction of Index Futures in India
References:
1.”Futures-Options and the Investor “ by Dr.C.K.Narayan
2. “Introduction to Futures and Options Markets” by John Hull
3. “Complete guide to Futures markets” by Jack Schwaeger.
Websites:
Swww.nseindia.com
Swww.bse.com
Swww.cboe.com
Swww.numa.com
Swww.investopedia.com